Digital Music Unplugged: Net Retailers Cuddle Up to Digital Distribution

While the music labels duke it out, music retailers embrace the technology.
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SAN FRANCISCO -- Just as software retailers like

Beyond.com

(BYND) - Get Report

and

Digital River

(DRIV) - Get Report

are betting that software will eventually be digitally downloaded, music retailers are getting ready for digital distribution of music. To promote its newly launched music store,

barnesandnoble.com

(BNBN)

offered a previously unreleased recording of

Jewel's

"Deep Water" for exclusive digital download from the site.

Amazon.com

(AMZN) - Get Report

announced plans to expand its free digital smorgasbord to have 38 songs from 22 artists.

CDNow

(CDNW)

teamed with

Atlantic Records

to offer a live version of a

Sugar Ray

single. And

Launch Media's

(LAUN)

Launch.com

Web site hosted previously unreleased

Beastie Boys

songs.

Although most digital songs are currently promotional freebies, the smallest advances in digital sales should produce some positive results for Internet music retailers. CDNow CEO Jason Olim says his firm plans to make entire albums available for downloading this fall. To bulk up its digital content, CDNow announced this week one partnership with online aggregator

CDuctive.com

and another with digital music wholesaler

amplified.com

to sell tens of thousands of downloadable songs and custom CDs. Still, the company isn't sure if that will mean a big chunk of revenue this year or next.

"Indirectly it's significant," says Olim, who expects sales of downloaded music to be cheaper for retailers, which could boost gross margins. There'll be no manufacturing costs, no transportation costs, no capital costs, no shipping costs and no return cost because there's no concept of an unused copy. "There'll be substantial savings in every area," he says.

"Digital

will

be an important part of the future," says Jonathan Bulkeley, CEO of barnesandnoble.com. Future is the key word. Bulkeley isn't sure when the technology would contribute to the company's revenue.

Jupiter Communications

says that only 3% of Net shoppers will buy digital versions of music by 2003, and Bulkeley believes mass adoption of downloadable music is seven to 10 years away.

Still, the formative days are now. The industry is where the online bookselling market was back in 1995, which proved to be the right time to move in. That's why Bulkeley feels it's important to start taking steps now. "It positions us as an innovator," he says.

And as the market develops, the retailers are likely to be among the biggest beneficiaries. Retailers sold records when eight-tracks went out of style, sold tapes when records went out of style, sold CDs when they were the latest technology and will sell digital music when the masses are ready to buy it.

It becomes less about the technology and more about the next way to buy music, says CDNow's Olim. "Are they buying music or a download?" he asks. "Most people are buying music." Bulkeley of barnesandnoble.com says, "We'll sell music in whatever format they want. We'll take our lead from what standards develop."

Just as retailers are ready to latch onto the technology, investors are ready to latch onto any company willing to take steps to be there first. When Launch Media, for example, announced the Beastie Boys tracks would be available exclusively on Launch.com, the stock jumped 13%. When Amazon said it would expand its digital music selection, its stock rose 2% on a day when

TheStreet.com Internet Sector

index was flat.

One wild card in the nascent market is consolidation, which is already starting. CDNow, for example, has agreed to

merge with

Columbia House

, a joint venture of

Sony

(SNE) - Get Report

and

Time Warner

(TWX)

. Sony and Time Warner will each own 37% of the new company; CDNow's existing shareholders will own the remaining 26%.

As players jockey for a prominent position, the market is growing. Music distribution (software sales, music sales and ad revenue) is expected to generate $65.1 million in 1999, nearly 50% more than the $43.9 million in expected sales of such music-listening devices as

Diamond Multimedia's

(DIMD)

Rio or Sony's minidisc Walkman, according to

Frost & Sullivan

, which tracks IT market trends. Last year, distribution generated $22.8 million; hardware sales were $18.9 million.

Part of the problem is bandwidth. It takes 25.7 minutes to download an average MP3 file, according to Frost & Sullivan. Another problem is the music industry's boot-dragging over the best way to control its property on the Internet. An industry coalition recently took steps to make digital versions of music available on a limited basis. Up to this point, audio files have been shared on the Internet for free. That meant music companies weren't making money on distribution.

Bandwidth Blues
Time required to download five minutes of music in an MP3 file

Source: Frost & Sullivan

"Everyone is grappling with the issue," says

Hambrecht & Quist

analyst Paul Noglows, a Launch Media underwriter who rates the stock buy.

Once digital downloading becomes the norm, customers will go to a particular site because of content that sets it apart from its competitors. Launch will emerge as the voice of music "just as

Rolling Stone

did in the '70s and

MTV

did in the '80s," says Noglows, because it is backed by the labels. Sony is an investor and strategic partner of Launch. That's the polar opposite approach of newly public

MP3.com

(MPPP)

, which works directly with independent artists.

Still, Launch generates its revenue from advertising, not music downloading. And neither Launch nor MP3.com has the brand or the customers that Amazon.com, barnesandnoble.com or CDNow has, a key factor that could push those three to lead positions once the labels come to a decision.